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3 Chip Stocks to Avoid as the Trade War Escalates

Leo Sun, The Motley Fool

The trade war between the U.S. and China is escalating into a full-blown tech war as the Trump administration tries to throttle sales of U.S. technologies to Chinese companies with a trade blacklist. This means that U.S. companies now need the government's permission to sell products to certain major Chinese companies like Huawei.

That move could cause collateral damage to any chipmaker that generates significant sales from China. Let's examine three chip stocks that are heavily exposed to those escalating tensions: Micron (NASDAQ: MU), Western Digital (NASDAQ: WDC), and Ambarella (NASDAQ: AMBA).

Two shipping containers adorned with the American and Chinese flags collide in the mid-air.

Image source: Getty Images.

Micron

Micron is the world's third-largest manufacturer of DRAM and NAND memory chips. DRAM and NAND prices peaked last year due to an oversupply of chips and soft demand from enterprise customers and device makers, and aren't expected to rebound until late 2020.

Micron generates nearly all its revenue from DRAM and NAND chips, so it was a better "pure play" on the market than diversified peers like Samsung as prices rose. However, the cyclical downturn is now punishing Micron more than its peers. Analysts expect Micron's revenue and earnings to plunge 23% and 47%, respectively, this year.

The trade war is exacerbating the pain, since Micron generated 57% of its sales from China last year. It recently halted chip shipments to Huawei in response to the Trump administration having blacklisted the Chinese tech giant, and that move will hurt -- Huawei's orders accounted for 13% of Micron's total sales in the first half of 2019.

To make matters worse, Chinese chipmakers recently unveiled their first domestically designed DRAM and NAND chips to curb the country's dependence on American tech. These chips won't be mass-produced to match Micron or Samsung's capacities yet, but they could drive down memory prices over the long term. All these factors make Micron a tough stock to own during the trade war, even if it seems dirt cheap at less than eight times forward earnings.

Western Digital

Western Digital is the world's largest maker of platter-based HDDs (hard-disk drives), the fourth-largest maker of NAND chips, and the second-largest maker of NAND-based SSDs (solid-state drives). Its HDD sales have been sliding due to sluggish enterprise demand, weak PC sales, and competition from SSDs, while sales of its flash memory chips and SSDs were crippled by low NAND prices.

As a result, analysts expect WD's revenue to fall 20% this year as its earnings plunge 67%. However, WD also recently cut ties with Huawei, which raises red flags at its Chinese business.

Four traditional hard-disk drives placed atop other disk drives.

Image source: Getty Images.

Western Digital stated that Huawei accounts for less than 10% of its overall sales, but it still generated 21% of its sales from China last year. WD's move could cause other Chinese tech giants -- like PC juggernaut Lenovo -- to reevaluate their dependence on WD's data storage devices.

If Chinese companies proactively cut their ties with WD, its sales and earnings could keep sliding and endanger its 5.4% yield, which has already consumed more than 100% of its earnings over the past 12 months. Therefore, WD's might initially seem cheap at nine times forward earnings, but its business will remain in free fall until it hits a cyclical bottom and trade tensions wane.

Ambarella

Ambarella makes image processing SoCs (system on chips) for various types of cameras. It rose to prominence as a supplier for GoPro, but it no longer generates significant revenue from the action camera maker. Instead, it sells its SoCs to a wide range of customers in the automotive, security, and consumer electronics markets. It also recently started selling computer vision chips for driverless cars.

Ambarella was already struggling before the trade war broke out: Intel started luring away some of its top customers with its Movidius computer vision chips, and it aggressively expanded into the automotive space with its takeover of Mobileye. Margins also contracted as Ambarella generated more sales from lower-margin SoCs for Chinese security camera makers.

As the trade war escalated, the Trump administration blocked sales of cameras from two of Ambarella's largest Chinese customers, Hikvision and Dahua, to U.S. government agencies. The U.S. is also reportedly considering adding both companies to its trade blacklist.

Morgan Stanley analyst Joseph Moore recently warned that Ambarella generated a "high teen" percentage of its sales from Hikvision. Ambarella doesn't disclose how much revenue it generates from China, but orders from Taiwan -- which serves many of its orders from Chinese ODMs -- accounted for 58% of its sales last year.

Wall Street already expects Ambarella's revenue to decline 9% this year as its earnings tumble 86%, which are dismal growth rates for a stock that inexplicably trades at nearly 80 times forward earnings. If the trade war cuts Ambarella off from its Chinese customers, investors should anticipate a lot more pain for this embattled chipmaker.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Ambarella. The Motley Fool has a disclosure policy.